Shock Persistence and the Choice of Foreign Exchange Regime : An Empirical Note from Mexico

July 2000 - Empirical econometric evidence shows that Mexico's simulated output recovery after a negative external shock was faster (a third as long) when the country's policymakers let the nominal foreign exchange rate float than when they fixed it, and much faster than in other developing countries that kept nominal foreign exchange rates constant, especially those that resorted to currency board arrangements to support that constancy. The academic and policy debate about optimal foreign exchange rate regimes for emerging economies has focused more on the theoretical costs and benefits of possible regimes than on their actual performance. Giugale and Korobow report on what can be called exchange-rate-regime-dependent differential shock persistence-that is, the time output takes to return to its trend after a negative shock-in a sample of countries representing various points on the spectrum of nominal foreign exchange flexibility. They find strong evidence that Mexico's simulated output recovery after a negative external shock was faster (a third as long) when the country's policymakers let the nominal foreign exchange rate float than when they fixed it, and much faster than in other developing countries that kept nominal foreign exchange rates constant, especially those that resorted to currency board arrangements to support that constancy. These results are insufficient to guide the choice of regime (they lack general equilibrium value and are based on a limited sample of countries), but they highlight an important practical consideration in making that choice: How long it takes for output to adjust after negative shocks is sensitive to the level of rigidity of the foreign exchange regime. This factor may be critical when the social costs of those adjustments are not negligible. This paper-a product of the Mexico Country Department, Latin America and the Caribbean Region-is part of a larger effort in the region to understand policy options open to developing countries for handling macroeconomic volatility in a globalized economy. The authors may be contacted at mgiugale@worldbank.org or akorobow@worldbank.org